(Bloomberg) -- If you buy low and sell high, chances are you’ll be richer and everybody will be happy. Sell low after borrowing high — what’s known as short selling — and you may be rich, but odds are that quite a few people will be displeased. Critics say that short sellers distort the market and that their practices can blur into market manipulation. “Shorts” say they’re keeping markets and companies honest. A series of negative reports from a short-selling firm, Hindenburg Research, have added fuel to the fire, as it targeted companies affiliated with Gautam Adani, one of Asia’s richest men, and by Jack Dorsey, one of the founders of Twitter.

1. How does short selling work?

Short sellers borrow shares, sell them, buy them back at a lower price and profit from the difference — unless the stock rises. Then they could lose money instead.

2. Who are the short sellers?

Most shorting is done by hedge funds and institutional investors to cushion their investments against falling stock prices or to bet that shares have risen too high. So-called activist shorts like Hindenburg, on the other hand, research companies to find targets that they allege have dodgy business or accounting practices, spread the word (sometimes anonymously) and, if all goes as planned, send the shares lower. Although activist shorts have been calling out companies for decades, their numbers have swelled with the rise of social media as a platform for disseminating theories and analysis.

3. What’s an example of short selling?

On March 23, Hindenburg Research took aim at Block Inc., the digital payments company co-founded by Dorsey that used to be called Square Inc. The activist firm said it was betting against the stock and published a report saying that Block’s Cash App was probably helping fraudsters take advantage of US government stimulus programs during the height of the Covid pandemic. It also alleged that Block was overstating how many people use Cash App and panned its $29 billion purchase of Afterpay, an Australian financial-technology company. The report sent Block shares tumbling. Block didn’t respond to requests for comment after Hindenburg published its report.

4. Is short selling illegal?

It’s legal in most major stock markets. What is banned either partially or fully in several markets is so-called naked short selling — betting on a stock’s decline without having first borrowed the shares. Even so, many markets issue temporary restrictions during periods of market turmoil — in part because critics say short sellers can transform downturns into full-blown panics. The US cracked down on short selling during the Great Depression and joined the likes of the UK, Germany and Japan in limiting short selling or banning it during the financial crisis that erupted in 2008. China’s regulator blamed “malicious” short selling in part for a stock market crash in 2015, placing limits on the practice as well as arresting traders. During the volatility that accompanied the onset of the pandemic in 2020, bans were imposed for several months in France, Spain, Italy, Belgium, Greece, Austria and South Korea, while the European Securities and Markets Authority ordered traders to disclose more information about short sales.  

5. Why is activist shorting especially controversial?

Opponents point to the ability of shorts to hoodwink investors by spreading false rumors before exiting a trade, a technique known as “short and distort.” Defenders say the potential for abuse shouldn’t discredit all shorts any more than “pump and dump” schemes disgrace all investors who whip up interest in a stock to push it higher and then sell it. Short sellers say they are skeptics who alert investors to bouts of market euphoria, identifying mispricing or deception that analysts, auditors and investors overlook. Many authorities dislike short selling — a former head of the New York Stock Exchange described the practice as “icky and un-American.” 

6. What is Hindenburg Research?

Hindenburg, founded by short-seller Nathan Anderson, describes itself as a forensic-research outfit operating with its own capital. But it follows the standard procedure for a so-called activist short: After researching a potential target, Hindenburg places a bet that the stock will decline, then trumpets its research publicly, using social media to get the message out. Anderson’s firm first attracted Wall Street’s attention in 2020 and 2021 for raising serious questions about electric-vehicle makers Nikola Corp. and Lordstown Motors Corp. It gained more prominence in February when it issued a 100-page report accusing the Indian conglomerate Adani Group of using a web of companies in tax havens to inflate revenue and stock prices, even as debt piled up. Adani said the claims were baseless and called them a “calculated attack on India.”

7. Is short selling new? 

Not at all. Dutch traders were shorting as long ago as the 1600s, including during the tulip bubble. Napoleon labeled short sellers of government securities “treasonous.” Short selling stocks — as opposed to tulips — is particularly challenging because equity markets have a long-term track record of moving up rather than down. Still, it can be done. Jesse Livermore, known as the “King of the Bears,” made a fortune shorting railroad operator Union Pacific shortly before the 1906 San Francisco earthquake. The collapse of Enron Corp. in 2001 marked a notable scalp for shorts including Jim Chanos, who had been among the first to question its accounting. Muddy Waters’ Carson Block (no relation to Block Inc.) raised the profile of the new breed of activist shorts by taking aim at under-the-radar Chinese companies listed in North America. The practice can be perilous: Block said he stopped shorting Chinese companies for a time because “tattooed gangsters” came looking for him. 

• Michael Lewis’s definitive take on the financial crisis, “The Big Short,” is also a movie starring Christian Bale, Steve Carrell and Brad Pitt.
• A 2020 Bloomberg article says short sellers made over $50 billion during the recent coronavirus sell-off, and another on a $14 billion bet by Bridgewater Associates, the world’s biggest hedge fund.
• A 2014 study, “The Invisible Hand of Short Selling,” found short sellers have a disciplining effect on various types of corporate earnings management.

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